A recent survey of the weather risk management industry has indicated a global increase of 43% in the number of weather-based financial transactions and 72% in the notional value for such contracts, in comparison with the previous year.* In order to maintain this rapid expansion market participants have sensed the need to enhance the legal environment in which such trades are executed and, in particular, to create a standardized documentation structure for weather transactions. Such a structure would expedite trades and enable companies to dedicate resources to weather risk management in order to improve market liquidity. Nevertheless, the nature of the underlying presents a series of obstacles, which renders the standardization process a challenging task and requires industry participants to openly discuss ideas and experiences in order to reach documentary uniformity.
Confirmation Standardization
As with most derivatives transactions, parties to a weather derivative generally enter into a market master agreement in order to define the relationship between the parties rather than to define the particular terms of a specific transaction. However, within the master agreement structure, parties to weather trades place a stronger emphasis than usual on the confirmation process which sets out the terms of each specific transaction and governs the financial flows between the parties. Accordingly, documentary standardization first materialized for weather derivatives within the confirmation process.
In 1999, Enron created the first standardized confirmations for weather-based trades and rendered them easily accessible for all users on its Web site. Shortly afterward, the Weather Risk Management Association expanded upon Enron's efforts and offered pre-printed standard temperature-based caps, floors, collars and swaps. Today, WRMA confirmations have become the de-facto standards in the marketplace.
Problematic Provisions Within The Confirmation
Even though they are presently considered market standards, today's WRMA confirmations contain a significant number of complex provisions that detract from the objective of achieving documentary simplicity in its purest form. Some of the most frequently disputed provisions and issues raised from within the WRMA standards include:
* Payment Date/Data Correction. For many derivatives
transactions, the Payment Date, as defined under the
architecture of the International Swaps and Derivatives
Association, is generally a straight-forward provision that
sets out the terms of when a party shall be paid pursuant to
a transaction following such a transaction's termination.
For a weather transaction, however, the issue of data
correction arises in relation to the Payment Date since it is
conceivable that a regional weather data provider, such as
the Japanese Meteorological Agency, which publishes data
a month after it is recorded, could publish data after the
Payment Date has elapsed. As a result, a second settlement
date may need to be established after the verification of the
data, which might cause grounds for dispute between the
parties. Allowing for such corrections clearly disturbs the
simplicity of the confirmation.
* Alternate Data Sources. The WRMA standard
confirmation contemplates climatic data as a primary data
source, which is usually the official weather station data of a
particular country and is quality controlled by the respective
national meteorological service and indicated as a weather
index station within the confirmation. Where data from
such a station is unavailable or unreported for a specified
period of time, the WRMA template confirmations outline
a complex methodology for determining alternative data,
referred to as the Fallback Methodology. There is a vast
array of adequate options that parties can choose from in
determining a fallback data source. For example, some
parties simply choose to employ synoptic data, which is
collected in real-time at various stations around the globe.
Others find this source unreliable, and choose to employ an
entirely separate weather index station as a fallback and
adjust the data accordingly.
* Negotiated Fallbacks. In a Negotiated Fallback settlement,
the parties determine an alternative data source amongst
themselves and handle adjustment in the event of a
continued failure to receive data. Some parties opt for the
decision to rest in the hands of the Calculation Agent,
which is to be determined between the parties upon
execution of the confirmation. There are other parties who
choose to rely on the close-out provisions of the governing
master agreement and employ a No Fault Close-out.
* Third Party Data Provider. In addressing the issues raised
by the Fallback Methodology, some participants would
prefer to rely on the data from a third party provider which
simply collates and publishes data in order to circumvent
the problems presented with the Fallback Methodology
systems and use of alternate weather stations.
* Rounding. There is often dialogue between the parties
concerning which rounding conventions should apply for
meteorological scales.
Collaboration Between ISDA & WRMA
WRMA has indeed been the long-time sole leader in the field of documentary organization for weather-based transactions, yet the association has never intended to compete with ISDA on the more general ground of organizing the contractual relationships between parties. In fact, WRMA confirmations expressly refer to the ISDA Master Agreement and are governed by its provisions, unless otherwise agreed to between the parties. Moreover, the present WRMA confirmations incorporate the ISDA 1993 Commodity Derivative Definitions by reference.
Therefore, it was a logical step for ISDA to create the Weather Derivatives Working Group as a collaborative effort between the two organizations in order to rapidly create an effective and unique standardized documentation structure. The group is divided into regional committees including the North American, European and the Asia/Pacific committees, which all work together through e-mail distributions, conference calls and gatherings geared toward modifying the existing WRMA forms of temperature-based confirmations and incorporating the needs of the marketplace. ISDA members including traders, dealers, business originators, legal specialists and many other market participants are encouraged to participate in the activities of the working group.
The members of the working group are planning to produce long form standard weather confirmations for common weather transactions to be published by ISDA. As WRMA has recently introduced average temperature and precipitation confirmations, the group is likely to also engage in a standardization process for these confirmations. Once the ISDA standard weather confirmations are complete, the group may incorporate certain consistent terms from the confirmations into an ISDA definitional manual specific to weather derivatives in order to further simplify the documentation process, as previously has occurred for credit derivatives.
The working group is also likely to address the calculation methods relating to the economic replacement value of certain operations. The general market practice has been to integrate an Exposure Calculation provision into the documentary framework, which is designed to determine margin calls for collateralized transactions and termination amounts for such transactions at the same time. The modification only concerns transactions (i) based on temperature and precipitation, (ii) for short term and (iii) whose references for an underlying in which the historical pattern is adequately complete to calculate on a historical result of 10 years.
Generally speaking, the formula consists of calculating a vector of 10 historical results by applying the operation methods relating to this historical data for each transaction. The replacement value of the concerned transaction thus results from the simple average of these historical results multiplied by a factor agreed upon between the parties. The termination amount of the weather-based transactions, or the exposure for the purposes of the collateral, is then calculated with the simple addition of these replacement values. WRMA has also recently produced a standardized Exposure Calculation provision, which is available on its Web site.
Finally, but on a more regulatory level, ISDA has included the treatment of weather derivatives in the scope of its annex to the netting opinions.
Once the documentary hurdles are surpassed, the growth of the weather market should be even more astronomical.
This week's Learning Curve was written by Debra Mitan, attorney, and Alban Caillemer du Ferrage, partner, at Gide Loyrette Nouel in Paris.
